Last year, the Government Actuary’s Department produced its quinquennial report setting out its recommended rebates for defined-benefit, defined-contribution and personal pension schemes for the five years up to 2012. This report seemed to bring good news for rebates. Changes in post-retirement long-term interest rate assumptions meant that rebates rose for all types of scheme.
However, the GAD report is only one part of the story. The recommended rebates are subject to agreement by Parliament. This is where the bad news starts. The Government accepts the GAD’s recommendations but only up to age 43, above which rebates to appropriate personal pensions are capped at 7.4 per cent of middle-band earnings.
This is a big departure from the last five-yearly period. For a start, the nominal level of the cap is much lower. From 2002-07, the cap was 10.5 per cent. Second, the age at which the cap bites is also lower at 44 compared with 55 in 2006-07. Finally, the anomaly that brought rebates back below the level of the cap for men aged 55 and over no longer exists.
Despite the slightly higher rebates for ages up to and including 43, these are still not particularly generous. Based on the GAD’s assumptions, rates of return above earnings inflation of between 2 and 2.5 per cent are needed to match the state second pension given up. This means that if wage inflation is 4.5 per cent, the nominal return needed is 6.5 to 7 per cent. The only way of achieving such a nominal return is to invest in a fund containing a high proportion of real assets, that is, equities and property. For those with more conservative investment tastes, the message is simple – contract back in to S2P this year.
Some people take the view that the rebate represents a bird in the hand which they consider more valuable than a promise from a Government of tomorrow. This is a perfectly legitimate view but not one that advisers should use in constructing recommendations. The Department for Work and Pensions and The Pensions Commission’s projections show that state pensions remain affordable well into the future. Predicted affordability still does not amount to a cast-iron guarantee but it is as near to that as possible.
Contracting out may still appear advantageous in a few cases, for example, for single men (rebates are calculated on a joint-life basis) or for those that prize death benefits. However, except in very exceptional circumstances, none of these reasons is strong enough to offset the financial gamble involved in giving up a defined benefit in favour of a money-purchase benefit.
Earlier this year, the FSA took a very close look at contracting-out cases from the late 1980s and early 1990s. It was concerned about cases contracted out above the pivotal ages. Expect it to retain a keen interest.
Advisers should make sure that they take positive action with clients aged 44 and over. Even if the client decides to stay contracted out, advisers should obtain the client’s written instruction documenting their insistence.
John Lawson is head of pensions policy at Standard Life